The EU Sustainable Finance Disclosure Regulation (SFDR) is a complicated regulation but the key to understanding its provisions is to think of it as a way to save the planet via your investment choices. It is designed to shift the flow of capital towards efforts that promote and enable a sustainable economy by setting strict disclosure standards. In this guide, we will cover how the SFDR works as well as the principal adverse impact.
What exactly is SFDR?
SFDR is a set of EU regulations that establishes disclosure requirements, which asset managers and other financial market participants are expected to adhere to. The regulations impose responsibilities on investment firms to disclose information on sustainability risks and principal adverse impacts.
The EU SFDR is aimed at providing investors with adequate information with which they can assess and compare sustainable investment options. Unlike previous years, the information is now presented in a more standardized way for decision-making. It also solves the problem of greenwashing by creating greater transparency around ESG claims so investors and the broad public can scrutinize the sustainability claims businesses provide.
Why is the EU SFDR important?
Before the SFDR came into force, several recommendations were devised by rating agencies, financial institutions, and other entities but no ESG reporting template gained acceptability across the board. SFDR creates a unified set of reporting standards and, thus, represents a major milestone in the move to the consolidation of ESG standards globally.
Going into the details of the EU SFDR, it can be summed in one word – disclosures. The SFDR is designed to help investors see how their investment choices affect the planet, thus helping them shift capital to activities that are less harmful and potentially, even positive.
Furthermore, it increases transparency on environmental and social characteristics and sustainability within the financial markets. It also makes it easier for investors to compare options with respect to how ESG factors are considered by organizations.
Who does EU SFDR apply?
The scope of the SFDR is quite broad as it applies to every financial market participant or financial advisor based in the EU. These include investment firms, pension funds, asset managers, insurance companies, banks, venture capital funds, credit institutions portfolio management, etc.
Although the SFDR applies to financial players in the EU, financial players that are also based outside of Europe but who market products to clients inside the EU are also affected. Because the scope of this regulation extends outside of the EU, many consider SFDR to be a point of no return, meaning it can only get greener from now onwards.
SFDR and Principal Adverse Impacts
Principal Adverse Impacts (PAI) regime is considered the most challenging part of the SFDR regulation. The concept stems from the fact that all companies have an impact on the environment, whether good or bad.
According to the EU, these impacts are “negative, material or likely to be material effects on sustainability factors that care caused, compounded by or directly linked to investment decisions and advice performed by the legal entity.”
Under this statement, financial market participants are required to collect ESG data and make extensive disclosures on any sustainability risks associated with their products. So far, the EU has highlighted 18 adverse impact indicators that firms must report with an additional 46 being voluntary. This brings the total number of indicators to be measured to 64.
The adverse impact indicators cover the standard environmental, social, and governance (ESG) factors. The mandatory indicators consist of:
- Environmental: Carbon emissions, fossil fuel exposure, and waste levels
- Social: Gender diversity and due diligence over human rights
- Governance: A firm’s record on exposure to corruption, bribery, and other scandals
Going forward, financial market participants are required to make two types of disclosures.
This level of disclosure works based on a “comply or explain” basis. It means participants must show they considered PAIs on sustainability factors of their investments. If they didn’t they must give reasons for their decisions and state (where necessary) whether they will consider them in the future.
The EU SFDR classifies products into three groups of disclosure rules based on their sustainability considerations:
- Article 6 financial products must disclose the manner in which environmental or social sustainability factors are integrated into the decision-making process and an assessment of the possible impacts of sustainability risks on such products or explain why such risks are not relevant.
- Article 8 Financial products promote environmental and/or social characteristics even if they do not have sustainable investing as a core objective.
- Article 9 financial products have sustainable investing as their core objective.
There is some misunderstanding among some asset managers regarding the difference between articles 8 and 9, raising questions on how to label their products. This is because of the use of the word “promote” in Article 8, which managers argue has no clear definition. The European Securities and Markets Authority is expected to issue further guidance to clear up the confusion.
Harnessing technology for SFDR regulation compliance
For corporate leaders, sourcing real-time, quality data has become increasingly critical as there is no basis for measurement without it. Even when relevant data is collected, the process of mapping into a singular and robust data model requires rigorous data quality checks to ensure accuracy.
To move past these challenges, financial market participants must move to leverage well-suited technological tools rather than work through manual mechanisms. These digital tools are cost-effective and time-saving solutions that can help wealth managers source data, identify risk factors, and more with greater accuracy.
The EU SFDR represents a major step toward regulating the sustainable finance space. Although most of the disclosure requirements already came into effect, the PAI statements will become mandatory in 2023. With the regulations, financial market participants must now do more to protect their reputations and attract investors who want to make better sustainable decisions.